Feb. 6 (Bloomberg) -- The U.S. lawsuit against Standard &
Poor’s raises pressure to accelerate competition in the ratings
industry while the government itself has adopted rules that left
the business dominated by the same companies whose flawed grades
sparked the worst financial crisis since the Great Depression.

The Justice Department accuses McGraw-Hill Cos. and its S&P
unit of deliberately understating the risk of bonds backed by
mortgages made to the riskiest borrowers to win business from
Wall Street banks. S&P, Moody’s Investors Service and Fitch
Ratings provided 96 percent of all ratings for governments and
companies in the $42 trillion debt market in 2011, versus 97
percent in 2008.

The lawsuit is unlikely to change the relationship because
a 2006 law intended to open the field to new entrants has
instead insulated the top three. Startups have struggled to
obtain the designation that lets them sell rankings because of
everything from a missing recommendation letter to prohibitive
compliance costs to being able to provide years of ratings
performance. Even as the biggest investors say they disregard
the grades, their use is still embedded in bond deals and bank
reserve rules.

The law “discourages entry and discourages new ideas and
new ways of doing things,” Lawrence White a professor of
economics at New York University’s Leonard N. Stern School of
Business, said in a telephone interview Jan. 24. “Ironically,
it reinforces the position of the big three.”

Judith Burns, a spokeswoman in Washington for the
Securities and Exchange Commission, which oversees applications
for ratings firms, declined to comment on the process.

NRSROs Formed

In 1936, at the depth of the Great Depression, the Office
of the Comptroller of the Currency banned banks from holding
bonds that were below investment grade, or securities rated
under BBB- by S&P and Baa3 at Moody’s. In 1975, SEC regulations
designated S&P, Moody’s and Fitch as Nationally Recognized
Statistical Rating Organizations, or NRSROs, and required some
investors to buy only securities stamped with the companies’
creditworthiness opinions.

Under rules outlined in the 2006 Credit Agency Reform Act,
there are now 10 NRSROs.

These changes have helped the seven smaller firms gain
market share from the big three in some asset classes. Kroll
Bond Rating Agency issued grades on $21.2 billion of commercial
mortgage-backed securities last year, the third most behind
Moody’s and Fitch, according to Commercial Mortgage Alert, an
industry publication. Toronto-based DBRS Ltd. has seen its CMBS
rating market share increase 125 percent to $16.5 billion.

Dodd-Frank Rules

Lawmakers targeted the credit-grading business in the 2010
Dodd-Frank Act after the collapse of top-ranked mortgage-backed
securities contributed to $2.1 trillion in losses at the world’s
largest banks. Reports from the U.S. Senate Permanent
Subcommittee on Investigations and the Financial Crisis Inquiry
Commission cited failures by the companies as a cause of the
financial crisis, which began in August 2007.

According to the complaint filed Feb. 4, S&P falsely
represented to investors that its ratings were objective,
independent and uninfluenced by any conflicts of interest. The
company shaped its analysis to suit its business needs to the
extent that one analyst of collateralized debt obligations said
loosening the measure of default risk for one security in 2006
“resulted in a loophole in S&P’s rating model big enough to
drive a Mack truck through,” the U.S. said.

McGraw-Hill, which agreed to sell its education unit to
Apollo Global Management LLC for $2.5 billion in November, fell
the most in 25 years after S&P said it expected the lawsuit.
Moody’s declined the most since August 2011.

‘Competitive Moat’

McGraw-Hill and Moody’s, both of New York, each had been
trading at five-year highs. McGraw-Hill, which ended last week
at $58.34, fell 10.7 percent yesterday to $44.92. Moody’s
declined 8.8 percent to $45.09, after a 10.7 percent drop on
Feb. 4.

A “competitive moat” around the top three firms has
resulted in virtually no change in their market share in the
last six years, Peter Appert, an analyst at Piper Jaffray & Co.
in San Francisco, wrote in a Jan. 24 report. Investors should
buy stock in McGraw-Hill, he said yesterday, because
“litigation risk has proven manageable.”

That moat has barely been breached by new SEC rules.

Too Costly

Ann Rutledge, a structured finance specialist, has watched
her application to become an NRSRO languish at the SEC for 20
months. Her company, R&R Consulting, has yet to be granted a
license because some of the eight client letters don’t meet the
requirements of a credit rating as defined by the 2006 law. The
statute specifies that only written testimonials that are
notarized from institutional buyers attesting to its ratings may
be used. R&R’s clients include pension funds, hedge funds and
governments.

Rapid Ratings International Inc., a New York-based firm
that uses quantitative models to grade securities, hasn’t
applied for the NRSRO designation, which would allow investors
to buy securities rated by the company to meet regulatory
requirements, because its costs would increase by 40 percent to
hire compliance staff, James Gellert, chief executive officer,
said in a Jan. 7 telephone interview.

“The SEC and Congress say what they want is more
competition in the ratings business, yet a lot of people define
ratings as being those from an NRSRO,” Gellert said. “We can’t
really rate much in structured products without having an NRSRO
already, so it boxes firms like us out of that market.”

Size Matters

Meredith Whitney Advisory Group LLC, headed by the former
Citigroup Inc. analyst, made a presentation to the SEC in
November 2010 seeking NRSRO status and has yet to be approved,
according to the SEC website. A woman who answered the phone in
the company’s New York office Feb. 4 declined to comment on its
application.

Costs have also kept PF2 Securities Evaluations Inc., a New
York company that values structured products, from applying for
the designation, according to Gene Phillips, a director.

Current regulation “encourages the proliferation of large
ratings agencies and discourages smaller and potentially more-focused companies from getting a specific license,” Phillips, a
former structured finance analyst at Moody’s, said in a
telephone interview Jan. 25.

While the SEC has 90 days to grant a company NRSRO status
after receiving its application, the process can take much
longer if the document is incomplete or out of compliance, or
the company lacks “adequate financial and managerial resources
to consistently produce credit ratings with integrity and to
materially comply” with requirements, according to the
regulator’s website.

Try Again

Rutledge’s firm, R&R Consulting, evaluates what structured
products are worth on a so-called fair value basis, as well as
giving the debt a letter grade. The firm was told it could
withdraw and reapply for NRSRO status, according to a December
e-mail exchange with the SEC.

“Our goal, in tying ratings to price and cash equivalents,
statistically and technically, is to move credit ratings into
the 21st century,” Rutledge wrote in an e-mail to SEC’s Diane
Audino Dec. 7. The SEC has yet to respond. The New York-based
company was founded by Rutledge and Sylvain Raynes, who co-authored “Elements of Structured Finance” and “The Analysis
of Structured Securities.”

Impeding Innovation

While the SEC can’t dictate ratings methodology, new
companies must use the same definitions for credit ratings as
the SEC. That restriction is impeding market innovation,
according to NYU’s White.

“Letter grades just can’t be the beginning and the end of
creditworthiness evaluation,” White, who’s testified before
Congress on credit ratings, said. “There’s got to be more ways
of doing things than this letter-grade approach.”

Most sophisticated investors no longer use credit ratings
to decide which bonds to buy, said Bill Larkin, a fixed-income
money manager who helps oversee $500 million at Cabot Money
Management Inc. in Salem, Massachusetts. Individual bond-buyers
still rely on the grades, he said.

“If you tell them something is AAA today, it’s just like a
brand,” Larkin said in a telephone interview. “It’s the only
thing they have to go on without digging through balance sheets
and looking at company fundamentals.”

Investors repudiated S&P’s decision to cut the top credit
grade of the U.S. in August 2011, with a Bank of America Merrill
Lynch index returning 9.8 percent that year, the most since
2008.

Reduce Influence

Even as the SEC has been working to reduce credit rater
influence, their grades are still entrenched in financial
regulation. The regulator has yet to decide how to remove
ratings in the $2.7 trillion market for money funds and in
determining what securities broker-dealers may own to meet
capital withholding requirements.

Efforts to curb the power of ratings companies are already
underway in the European Union. The bloc’s 27 governments are
set to rubber stamp measures, approved on Jan. 16, that aim to
make it less likely that decisions on sovereign debt roil
markets. The proposals will also give investors the right to sue
if they lose money because of poor quality or deliberately
distorted credit assessments.

Capital Rules

The latest global capital rules from the Basel Committee on
Banking Supervision still use credit ratings, except in the
U.S., where regulators were instructed by the 2010 Dodd-Frank
Act not to use them. Regulators say they’ll determine how much
capital banks must hold to back bonds by looking at criteria
similar to those used by the ratings firms.

Because Dodd-Frank affects regulation only at the federal
level, many state and local pension funds still rely on the
opinions.

Egan-Jones Ratings Co. was barred from grading government
debt and asset-backed securities for 18 months after settling
claims it made material misstatements to the SEC last month. The
company misled the regulator by asserting it had been ranking
the two asset classes since 1995 when registering for NRSRO
status, the SEC said in a statement. In fact, the closely held,
Haverford, Pennsylvania-based company started rating the debt in
2008, the year it applied for the designation.

Demand for credit ratings reached a record last year as
companies sold an unprecedented $3.95 trillion of bonds with the
U.S. Federal Reserve holding interest rates between zero and
0.25 percent since 2008.

Moody’s and S&P are able to raise prices because the two
are a “natural duopoly,” Warren Buffett, the billionaire
chairman of Omaha, Nebraska-based Berkshire Hathaway Inc., told
the inquiry commission in 2010. Berkshire is Moody’s largest
shareholder, with a 12.8 percent stake.

So far, the rules haven’t dented Moody’s market share.

“The regulation is very onerous,” Mark Adelson, former
chief credit officer at S&P and current chief strategy officer
for municipal bond insurance startup BondFactor Co., said in a
telephone interview. “It sets up a very high barrier to entry
and it’s very hard for a fledging rating agency to really get
going.”